The Debate on Corporate Tax Reform Just Started for Real

Executive Summary

President Trump’s announcement of his proposed tax reforms, as skeletal as it was, is better news than most commentators have suggested. First, it signals that the administration is coming to the view that tax reform is the most important agenda item for the first term – and that is great news. Second, the fact that the corporate piece of the proposal did not embrace the Brady-Ryan plan and its so-called border adjustment tax is also good news. The bad news is that the outlines released by the Trump administration are skinnier than most campaign proposals and don’t resemble anything like a real legislative effort. It also gets one big thing very wrong: it creates a very low rate for business income on pass-through entities. Taken together, and most importantly, the reform plan the administration has offered is fiscally irresponsible, and it relies on heroic assumptions about the economic growth that the tax cuts would trigger. The timing seems clearly motivated by the 100-day marker, and so the proposal appears to have been rushed out without thoughtful elaboration.

President Trump’s announcement of his proposed tax reforms, as skeletal as it was, is better news than most commentators have suggested. First, it signals that the administration is coming to the view that tax reform is the most important agenda item for the first term — and that is great news. Second, the fact that the corporate piece of the proposal did not embrace the plan proposed by House Ways and Means Chair Kevin Brady and Speaker Paul Ryan, and its so-called border adjustment tax, is also good news. So, there is some good news in what it signals and what’s not in it. What about what is in it?

As for the details, such as they are, it’s a very mixed bag. Let’s take the individual and corporate parts of the proposal in turn.

On the individual side, there are several important pieces to Trump’s announcement:

Fewer brackets and a lower rate on the top bracket

A doubling of the standard deduction

Repeal of the alternative minimum tax

A restriction of deductions, particularly the state and local tax deduction

Repeal of the estate tax

Repeal of the additional tax on investment income that was part of the Affordable Care Act

The president’s proposal is right to focus on brackets — the proposal just goes in the wrong direction. We do need bracket simplification, but we also need a new higher bracket. Because high incomes have risen faster than inflation, today 1% of Americans are in the top bracket. Historically, it’s been closer to 0.1% of Americans. As a result, the highest tax bracket lumps together people in vastly different circumstances, from those making $450,000 to those making tens of millions of dollars. Creating a new tax bracket at a higher rate of 45% on income above $1.25 million would raise considerable revenue and would make it less necessary to rely on stealth tax increases such as phasing out deductions and exemptions. That new bracket would also help address the growing appetite for redistribution in a more focused way.

The proposal to double the standard deduction is being positioned as an effort to provide tax relief to the middle class by increasing the number of people who owe zero income tax after deductions. This is a very costly and inefficient way to help the middle class. More than half of Americans don’t pay the income tax, so a generous expansion of the standard deduction would go largely to people in the upper middle class and above. It would also be available to high-income folks and, because it’s a deduction, is most valuable to people facing a high tax rate, meaning people with high incomes.

A better way to help the middle class would be through a significant expansion of the earned income tax credit. This would help lower-income Americans who need it most, provide excellent work incentives, and not reward high-income individuals. Even if the goal is specifically to expand the number of people who pay no income tax, there’s a much easier and cost-effective way than doubling the standard deduction: Do it explicitly by exempting Americans below $100,000 from taxes altogether.

Repealing the Alternative Minimum Tax (AMT) and limiting most deductions other than mortgage interest and charitable contributions is relatively good news. The restriction of deductions is an important step toward the goals of simplifying the tax code and raising more revenue, and it is relatively progressive. Repealing the AMT would reduce complexity considerably. And they have nicely offsetting effects. People in coastal (and largely Democratic) states are more likely to both pay the AMT and have the largest state and local tax deductions, so they win a little and lose more than a little. Repealing the surtax on investment income and repealing the estate tax are nice simplification measures but are largely targeted toward very high-income taxpayers.

The news on the corporate side is better. The U.S. corporate tax system is woefully equipped for current global realities. The statutory rate of 35% is dramatically higher than that of many of our trading partners, while the average rate — what firms actually pay — is considerably lower than the statutory rate. Such a system creates distortions without collecting as much revenue as the high rate would suggest. Finally, the U.S.’s worldwide system of taxation is also out of step with the rest of the world; unlike many of our peers, we tax profits made overseas by U.S. companies. That has led firms to leave the country, either explicitly or by being bought by foreign firms and redomiciled.

The administration’s recent announcement is also good news because it appears to be turning away from the more radical business tax reform envisaged in the Brady-Ryan plan. That plan has dominated tax reform dialogue for the last six months, and unfortunately so. The Brady-Ryan plan is based on a “destination-based cash flow tax” (DBCFT) that is also mistakenly labeled a “border-adjustment tax” and has five critical features:

A reduced rate, down to 20%

Expensing of all capital investments

No net interest deductibility

The exemption of export revenues and the nondeductibility of imports

An effective shift away from a worldwide income tax

What does all that add up to? Well, no one really wants to say it, but it’s effectively a value-added tax (VAT) with a wage subsidy. VATs are employed around the world, but wages are typically not deductible. So, it’s a tax on consumption rather than income, which is good. But it uses corporate cash flows to do it, rather than the way the VAT works around the world: through the so-called credit invoice method, where businesses are taxed on sales but deduct taxes paid on inputs.

In other words, the Brady-Ryan plan imagines using the U.S. tax system to experiment with a set of reforms that haven’t been tried anywhere else around the world. It would bring enormous risks including, but not limited to, (1) a very sharp exchange rate movement that could lower the value of all the assets held by U.S. citizens abroad, (2) the possibility of considerable financial instability, triggered by the increasing value of dollar-denominated liabilities, (3) a trade war initiated by the World Trade Organization, which likely will rule that the tax is not WTO compliant, (4) a wave of mergers, triggered by the presence of companies with structural losses (exporters) and companies with enormous paper profits (retailers), and (5) considerable uncertainty over how pass-throughs and financial institutions would be treated.

These risks might be justified if there were commensurate rewards. But many of the rewards of the DBCFT are oversold. A cash flow tax like the one in the Brady-Ryan plan might actually raise the tax rate on marginal investments, compared to the status quo of interest deductibility and accelerated depreciation. And, most notable, the key element of the reform is the accounting gimmickry that it relies on: Its treatment of exports and imports means that the bill is scored, to use the Washington parlance, as not costing nearly as much revenue as it really does. In fact, that gimmickry is a leading reason why many in Washington, D.C. like this plan.

So it’s good news that that we seem to be moving away from this more radical approach to tax reform. The bad news is that the outlines released by the Trump administration are skinnier than most campaign proposals and don’t resemble anything like a real legislative effort. The timing seems clearly motivated by the 100-day marker, and so the proposal appears to have been rushed out without thoughtful elaboration. The proposal does get two big things right — a reduction of the rate and a move away from taxing the worldwide income of multinational firms domiciled in the U.S.

It also gets one big thing very wrong: It creates a very low rate for business income on pass-through entities, a category that includes sole proprietorships, partnerships, and S corporations. This is being framed as a way to bring the rates on pass-through entities in line with corporate activities, but is really just a massive tax cut for higher-income folks who use pass-throughs. As such, it falls prey to the ridiculous rhetoric that excessively valorizes “small businesses” and equates small businesses with pass-throughs. Moreover, it can create a large hole in the income tax by creating incentives to disguise labor income as business income by creating pass-throughs. If anything, we should be considering a small tax on pass-throughs at the entity level. That would be progressive and would counteract the tremendous advantage that pass-through entities currently enjoy compared to corporations.

Fortunately, the outline of the Trump plan points toward a reasonable path forward. The last really serious effort at corporate tax reform was undertaken by former U.S. Representative Dave Camp when he ran the House Ways and Means Committee. The broad outline of that reform was a reduced rate, a shift away from territoriality, some revenue increases by adjusting investment incentives, and some efforts to curb transfer pricing. That corresponds to my own efforts to reimagine the U.S. tax system, and I believe it is the right approach to reform.

Taken together, and most important, the reform plan the administration has offered is fiscally irresponsible, and it relies on heroic assumptions about the economic growth that the tax cuts would trigger. Given the U.S.’s long-term fiscal challenges, this is not acceptable. And it points to the fact that, in the near future, we will need a traditional VAT consumption tax and/or a carbon tax. These are excellent tax instruments, which raise revenue efficiently and counteract the considerable externality associated with carbon emissions. Finally, if the administration were really interested in simplification, iy would embrace the “ready return,” a plan in which the government would prepopulate tax returns for taxpayers, considerably reducing complexity and compliance costs.

But the proposal by the Trump administration is an opening gambit and little else. It won’t resemble where we end up, but it signals an appreciation for the importance of tax reform to the future of economic growth in the U.S., and that is a good place to start.